Stimulating.

Photographer: Martin Leissl/Bloomberg

Debate: Is More Easy Money Good for Europe?

Clive Crook is a Bloomberg View columnist and writes editorials on economics, finance and politics. He was chief Washington commentator for the Financial Times, a correspondent and editor for the Economist and a senior editor at the Atlantic. He previously served as an official in the British finance ministry and the Government Economic Service.
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The European Central Bank announced a new stimulus package Thursday as part of its program intended to goose Europe's lethargic economy. Jean-Michel Paul, a London-based investment manager and Bloomberg View contributor, wasn't impressed. Clive Crook, of the Bloomberg View editorial board, was supportive. They compared notes here. What's your view? Please let us know by adding a comment below.

Jean-Michel Paul: The ECB's decision for more stimulus was as expected for the most part. But I wonder what it will produce. In the past 18 months M1 -- base money in circulation -- in Europe has risen to 6.5 trillion euros from 5.5 trillion euros. Market interest rates have dropped in line with the sovereign bond acquisitions done to achieve this. Yet loans to the private sector in Europe have been poor, and consumer prices have barely risen. This is not a classic liquidity trap, but rather a credit trap.

Money is pushed into the system, but there is little real private demand for it, as this chart shows (M1 is the green line, private-sector loans the red line). So what is the point of pushing more money into the system under these conditions, I wonder.

Private Loans Don't Track M1 Money Supply

Source: Bloomberg

Clive Crook: Monetary policy can't do everything, and it's true that the policy has come to a point of diminishing returns. But the returns aren't yet zero or negative. The program has eased credit conditions, as Mario Draghi, the ECB president, said in his press conference. It has made loans in Europe cheaper and easier to get than they'd have been otherwise.

Europe's QE Quandary

Loan demand is still subdued, as you say, but this doesn't show that quantitative easing is useless. What's the counterfactual? Without QE, interest rates would have been higher and lending would likely have been lower still. It's entirely plausible that the recovery would by now have stalled entirely and that deflation would be well entrenched.

I'm sure we agree that QE isn't enough. But it's all we've got. In my view, the best macroeconomic approach would also involve closer fiscal coordination and a big increase in euro-wide public investment. But that isn't happening and it's hard to see how that might change. I acknowledge, too, that QE involves risks. But I think they're manageable, and in any case they have to be weighed against the need for further stimulus.

It's a shame that the ECB is having to carry the whole of this burden -- something it isn't well equipped to do. But nobody else is stepping forward.

Jean-Michel: So monetary policy cannot do everything, that is true. But let's ask what should it do? If the money created by the ECB is not going toward private lending, what's happening? 

The ECB says it must act because consumer inflation rate is 1 percent rather than its targeted 2 percent. Changes in the consumer price index basket or computing methods -- and even measurement errors -- have been known to have a margin of error of about this magnitude (between 0.3 and 1.4 percent). I would say the ECB makes too much fuss over just 1 percent. Now consider the consequences.

There are two kinds of prices. The first is consumer prices -- the cost of things we buy -- which are declining, mainly because technology has not brought radically new products to the market (is the new iPhone really revolutionary?) but rather is making existing products and services cheaper (think Uber).

The other kind of price we can call the price of savings -- assets we purchase now to be able to consume later, such as stocks and real estate. And that’s exactly where QE money is going -- into stocks and real estate. (In the chart below, you can see how German stocks, in red, and the money supply, in green, have risen together.) However, that does not make it more productive. It does not make us better off. It is just setting the stage for the next bubble and the next crash. The more the ECB prints, the larger the bubble, the more painful the fall will be.

So my question is, how can monetary policy be effective in increasing demand rather than creating asset bubbles?

German Dax Tracks Euro M1 Money Supply

Source: Bloomberg

Clive: There are (at least) two questions here. One is whether the euro area is suffering from a deficiency of demand. The other is whether QE can do anything to narrow that deficiency, supposing it exists.

What you say about errors in measuring consumer-price inflation and the current form of technological progress makes me wonder if you're saying there's no lack of demand. I would find that position hard to understand, given Europe's high unemployment and other evidence of a persistently large gap between actual and potential output. You might agree, at least, that the consensus among analysts is that Europe has an output gap -- i.e., that there's a shortfall of demand. For the sake of clarity, do you disagree with that consensus? The need for QE, or any kind of demand-side stimulus, arises in the first place only if there's a shortfall of demand.

Setting aside whether more demand is needed, if I understand you correctly, you're arguing that QE fails to provide extra demand, and delivers asset-price bubbles instead.

Isn't this self-contradictory? If QE causes stock markets and house prices to rise -- and I agree that it does -- then by the same token it must surely raise demand. Again, consider the counterfactual. Suppose there'd been no QE. Then, on your own analysis, stock markets and house prices would not have recovered as much as they have, wealth would be less, and demand would be lower. Perhaps, in your view, there's no demand shortfall right now; but there would have been, if not for QE.

It's true that by raising asset prices, QE runs the risk of inflating bubbles that will burst, causing renewed instability. Conventional monetary policy runs that same risk in more normal times, because it too works in part by affecting asset prices. It's a risk that has to be balanced against other dangers, such as leaving people and resources unemployed, permanently eroding the economy's productive potential and (in current circumstances) letting the economy subside into a deflationary spiral.

To my mind, in the absence of effective fiscal policy, that balance argues for continued and expanded QE. But, as I say, the question doesn't arise if you think there's no lack of demand. Is that what you think?

Jean-Michel: There is a demand problem, and this is ultimately why so unconventional a measure as QE is attempted -- not because inflation is reported to be one percentage point below a given target.

But it's worth specifying how that lack of demand shows up. In particular, in the more indebted countries, real economic demand is sagging.  My old professor -- now ECB chief economist -- Peter Praet uses this graph to illustrate the difference in demand between what he calls the "vulnerable" euro-area countries (which include, among others, Greece, Ireland, Spain, Portugal and Italy) and the rest of the EU:

Demand Differences in the Euro Zone

Source: Eurostat and ECB calculations

That is entirely consistent with the view that QE may still be creating asset bubbles. In the current "credit trap," most of the QE money goes toward savings rather than what we might call "real goods." Thus, it results in large increases in the price of stocks and real estate. But it fails to a large extent to boost the demand for goods and services. This is why I am skeptical that QE will work and why I think it can potentially do some real harm.

QE, to my mind, is a bit like a blood transfusion. While the patient is undergoing surgery, a blood transfusion makes sense. Too much of it would be useless, but it is required for the surgery to be successful. Here we have no surgery -- which would be structural reforms or fiscal stimulus. So we are left relying only on QE, whose marginal returns are diminishing quickly and which has indeed increasingly negative risks associated with it.

The ECB is flooding the financial system with liquidity that I would argue builds up bubbles that could be dangerous when they burst. I can see how that would work in a federal country like the U.S., where fiscal and monetary policy work hand-in-hand. But how do you make it work in a currency union where central banks are in fact more like currency boards and the federal budget is only about 1 percent of GDP?

Clive: I only wish it were true that fiscal policy and monetary policy have worked "hand in hand" in the U.S. Even there, the Fed was left to carry most of the burden of stabilization policy (though it wasn't left entirely alone in the task, unlike the ECB). Still, I agree with you on the larger point -- that Europe is less well-placed than the U.S. to make a success of QE.

The required demand stimulus varies more from nation to nation in the euro area than it does from state to state, or region to region, in the U.S. That puts monetary policy, which affects the currency zone as a whole, at a comparative disadvantage in Europe. Fiscal policy is better adapted to EU conditions; yet, as I say, intelligently coordinated fiscal policy has been completely absent there. In addition, Europe has been been much slower than the U.S. to confront the problems in its banking and finance sector, so the channels that connect QE to final demand have been partially blocked. I think you're right to underline that point. 

In the balance of risks I talked about before -- the temporary and permanent economic losses due to deficient demand, versus the risk of inflating asset-price bubbles -- Europe's economic conditions and financial-policy failures do subtract something from the case for QE, as compared to the U.S. The question is whether they weaken the case enough to say, "Don't do it."

I think not. For sure, it would be far, far better if Europe's governments could bring themselves to mend their fiscal policies and move faster on financial reform. Then Europe would need less monetary stimulus, conventional or unconventional. But they can't, or anyway won't. This is the ugly reality the ECB has to face. So I continue to think that Draghi was right to embark on large-scale QE, that if anything he should have started sooner, and that he might yet need to do more.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the authors of this story:
Clive Crook at ccrook5@bloomberg.net
Jean-Michel Paul at JPaul@acheroncapital.com

To contact the editor responsible for this story:
Therese Raphael at traphael4@bloomberg.net